The Corporate & Commercial Law Society Blog, HNLU

Tag: business

  • Revamping Venture Capital: SEBI’s Progressive Amendments for Dynamic Fund Migration

    Revamping Venture Capital: SEBI’s Progressive Amendments for Dynamic Fund Migration

    BY SHRIYANSH SINGHAL, SECOND-YEAR STUDENT AT NLU, ODISA.

    Introduction

    On July 20, 2024 the Securities Exchange Board of India (‘SEBI’) amended SEBI (Alternative Investment Funds) Regulations, 2012 significantly. Subsequently, guidelines were released by SEBI to these amendments which are particularly concerning the VCFs which were earlier governed under SEBI (Venture Capital Funds) Regulations, 1996. The change to the Alternative Investment Funds (‘AIF’) Regulations is advantageous to Venture Capital Funds (‘VCF’) as it provides more freedom to the VCFs especially in regard to unliquidated investments at the end of the tenures. The changes are in consonance with SEBI’s intention to amend the legal provisions governing the venture capital funds to suit the current market conditions.

    SEBI has been advancing AIF as an ideal investment vehicle in India which has facilitated all forms of funds including venture capital funds, private equity funds and infrastructure funds. As more investors are investing their money in AIFs, SEBI has also upped its ante to make sure that such funds operate in the most transparent manner and for the benefit of the investors. These amendments are a doctrinal transformation of the existing legal framework, to enable VCFs transition to this new flexibility, which improves operational effectiveness and investors’ safeguards. This way, SEBI modernises the previous regulations, adapting them to the present conditions of the market and presents AIFs as a primary stimulator of innovation and investments in the Indian economy.

    Rationale Behind the New Guidelines

    The rationale for the development of these new guidelines is anchored on shifts that have taken place in the investment climate in India. The VCF Regulations were introduced in 1996 and at that time they were rather innovative. However, the changes in the venture capital industry continue and the regulations have become outdated. The introduction of the AIF Regulations in 2012 was a significant improvement as it offered a more complex and flexible framework for various structures of AIFs including VCFs. However, there were still many VCFs that have been registered under the old regulations but still operated under a structure that was not completely appropriate to the industry’s needs.

    The changes in the amendments are directed to the increase in the demand for the harmonization of the regulations and the flexibility. SEBI has provided these VCFs an opportunity to migrate to the AIF Regulations and therefore, avail the benefits of a relatively modern framework. This has included the improvement of the management of unliquidated investments which is crucial to funds that are in the final stages of their life cycle. Also, the amendments seek to bring all funds as one so as to enhance the protection of investors as it is easily regulated.

    Deciphering the Amendments
    • Migration of VCFs to AIF Regulations

    The essence of the amendments is in the possibility of the VCFs’ transition to the AIF Regulations. This migration is not compulsory but is very advantageous for anyone who decides to migrate. These changes are beneficial as they allow VCFs to operate through a modern, flexible framework, offering longer liquidation periods, better regulatory reporting and increased investor protection which will lead to improved handling of unliquidated investments and transparency overall. This flexibility is accompanied by the migration deadline of July 19, 2025, which provides VCFs with enough time to take decision about the transition.

    The amendments to the AIF Regulation in contiguity with VCF Regulations are expected to have significant effects on India’s venture capital industry. An increase in the regulatory cohesion by SEBI can be enforced by encouraging VCFs to migrate to the AIF framework which will lead to simplification in compliance maintenance by fund managers and clinch all funds under a unified set of regulations.

    • Additional Liquidation Period

    Another significant amendment is the provision for a one-time additional liquidation period. VCFs with schemes whose liquidation period has expired but have not yet wound up their operations can now apply for an additional year to complete the liquidation process. This extension, valid until July 19, 2025, provides much-needed breathing room for fund managers, allowing them to manage their exits more effectively and avoid fire sales that could harm investor returns.

    As for the VCFs with the schemes which have not yet achieved the end of the liquidation period, the migration enables such funds to remain active within the framework of the AIF Regulations. Also, it is important to note that if a fund’s scheme had a defined tenure under the old regulations, such tenure remains frozen on migration. But if no tenure was previously fixed, the fund has to fix a residual tenure with the concurrence of at least three-fourth of the investors. This provision helps to protect the investors and also helps the fund to operate in a very transparent manner.

    • Enhanced Regulatory Reporting in case of non-migration

    In case VCFs do not migrate, SEBI has come up with improved regulatory reporting standards. These funds will be more regulated and if they continue to exist beyond the liquidation period they will face regulatory actions. This aspect of the amendments acts as a form of threat that will compel VCFs which are no longer actively investing to either join the AIF framework or wind up their operations.

    The amendments also specify circumstances under which migration is not possible. VCFs which have no more active investments or have wound up all their schemes are expected to surrender their registration by 31st March 2025. Otherwise, SEBI will proceed to cancel their registration as the latter failed to meet the requirements provided by the former. This provision helps in avoiding the creation of a bureaucratic burden on the regulatory framework by funds that are inactive or dormant, thereby enabling SEBI target active participants in the market.

    The potential of increased fund activity with the option to migrate to a relatively modern regulatory framework, may incentivize VCFs to launch newer schemes or extend the life on present ones. Hence, benefiting both investors and the broader economy by increased activity in the venture capital space. The stipulation for inactive VCFs to surrender their registration will streamline the regulatory landscape. Consequently, ensuring that only active and compliant funds are registered and as a result, reducing administrative burdens and allowing SEBI to focus on more significant regulatory issues.

    • Strict Compliance and Accountability

    Lastly, the amendments impose a great deal of obligation to the managers, trustees, and other personnel of both VCFs and Migrated VCFs. These people are responsible for compliance to the new regulations and they will have to fill and submit the Compliance Test Report to SEBI. This report which is a compliance to the SEBI Master Circular for AIFs is an important mechanism of ensuring that the industry is accountable to the public.

    There can be an enhancement in the investor protection steps taken by SEBI to assure investors that their interests are being safeguarded within a robust regulatory framework. This can be done by necessitating investor approval in ascertaining the tenure of migrated schemes and the insistence on compliance reporting.

    Forging new Horizons

    The modifications carried out to the SEBI (Alternative Investment Funds) Regulations, 2012 are a welcome change for the enhancement of the venture capital funds in India. In the future, SEBI should focus at giving the required assistance to those VCFs that wish to opt for the AIF structure by issuing appropriate instructions and keeping the concerned parties informed. This will assist VCFs to address the operational and compliance challenges of the migration process appropriately. SEBI could also contemplate on the need to carry out regular audits of the framework with a view of making changes that could help to address some of the problems that may arise after migration as well as to ensure that the regulations are up to par with the best practices in the international markets. Moreover, enhancing the investor awareness and increasing the transparency of the mechanisms will help to increase the confidence in AIFs and therefore the capital will flow into the venture capital more freely. Therefore, SEBI can contribute to the formation of the startup market and the non- traditional type of financial instruments in India due to the formation of a more integrated and adaptable system of regulation.

    Conclusion

    The proposed amendments to the SEBI (Alternative Investment Funds) Regulations, 2012 are huge in the growth of venture capital industry in India. Thus, SEBI is ensuring that the regulations are relevant and comprehensive by providing VCFs a chance to move from the VCF Regulations to the AIF Regulations. The emphasis on flexibility, investor protection and compliance are very much seen in the SEBI’s attempt to make the investment environment healthy and active. To the fund managers, investors and the market in general, these amendments introduce a new dimension of understanding and certainty which would help foster the future growth and development of the industry. In the long run, the value of the integrated and updated regulation of the industry will be seen as it adapts to the changes that have been identified.

  • The Religare-Burman Saga: A Wakeup Call To Review Our Takeover Code?

    The Religare-Burman Saga: A Wakeup Call To Review Our Takeover Code?

    BY AAKRITI RIKHI, THIRD YEAR STUDENT AT NATIONAL LAW SCHOOL OF INDIA UNIVERSITY, BENGALURU

    I. Introduction

    On 10th July 2024, the Securities Appellate Tribunal (“SAT”) ordered Religare Enterprises Ltd. (“REL”) to comply with the Securities and Exchange Board of India (“SEBI”) order vis-à-vis the open offer by the Burman Group. This was in light of opposition by the board of directors (“Board”) of REL, the target company, to the proposed acquisition. The interim order by SEBI blocks all attempts by the Board to oppose such a takeover, even as the Board may act in the interests of the stakeholders of the company. [GA1]  The fundamental problem with this order is SEBI’s notion that the Board is accountable to the shareholders only (when a hostile bid is made) and not to all stakeholders of the company. 

    This decision in effect, solidifies the Indian position on hostile takeovers. Hostile takeovers are allowed as long as there is a compliance with the Substantial Acquisition of Shares and Takeovers (“SAST”) Regulations[GA2] , 2011. As per these regulations[GA3] , a limited set of responsibility is upon the Board of the target company, which is owed to the shareholders only. Upon a public announcement of an open offer for acquiring shares of the target company, the Board of the target company cannot act on the offer [R24] without the approval of the shareholders. This, I argue, is extremely constraining. Considering the shift towards the stakeholder model as codified by Section 166 of the Companies Act, 2013[GA5]  (“the Act”), it has become necessary to bestow some scope to act to the Board in the case of a takeover. The current legal framework has not accounted for this shift and as a result, there is a clear imprint of the shareholder-primacy model. 

    This post proposes a re-evaluation of the current legal framework to bring it in line with Section 166 the Act. It does so by firstly, highlighting the problematic assumption of the SEBI order in Religare. Secondly, it rebuts this assumption through a brief analysis of the model followed by India vis-à-vis the duties of directors and finally, using this analysis, it argues for empowering directors with the scope to act during hostile takeovers. 

    II. Analysing the SEBI order: An imprint of the shareholder model

    In the case of REL, prior to the public announcement for acquisition of more shares, the acquirers held 21.54% shares of REL. With the proposed acquisition, the shareholding of the acquirer would have increased beyond 25%, triggering an open offer under Regulation 3(1) and 4 of the SAST Regulations, 2011[GA6] . In relation to this open offer, the Board of REL had constituted a Committee of Independent Directors, which had raised objections to the proposed acquisition, on the ground that the acquirers were not ‘fit and proper’ persons for acquiring shares in the target company. There was no evidence provided in support of these allegations.

    In its interim order, SEBI held that the refusal of the target company to seek statutory approvals from regulators, which would enable the acquirers to discharge their legal obligations and provide an exit option to shareholders in the open offer, defeats the objects of the law and goes against the established canons of corporate governance. As per SEBI, the management of the target company is a representative of the shareholders and cannot act against their rights and interests.

    This ignores the fact that directors owe fiduciary duties to the company and not merely to the shareholders. The fundamental problem with this order is the assumption that shareholders are the only decision-makers of the company. By accounting for only the shareholder’s interests, the order renders the stakeholder model of the present statute otiose and is problematic for the target company. 

    This is symptomatic of our present legal framework for hostile takeovers as the following section will explain.

    III. Duties of Directors during a hostile takeover under the current legal framework

    During an acquisition, the management of a listed company is duty bound to act in the interests of its shareholders under broader corporate governance norms, enshrined in the provisions of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. Regulation 4(2) imposes a mandatory duty on the listed company to protect and facilitate the exercise of the rights of shareholders. This is also reflected in the SAST Regulations 2011. As per Regulation 26(2) of SAST Regulations, the Board of the target company cannot take any substantive action without a special resolution of the shareholders. Further, the Board has to constitute a committee of independent directors to provide reasoned recommendations on an open offer. These recommendations have to be provided to the shareholders of the target company. The Board only exercises an advisory role wherein it has no choice but to facilitate the acquirer in the open offer process. This is consistent with the U.K. Takeover Code. This code has enshrined similar provisions on the duty of the Board in case of a takeover. This is termed as the ‘non-frustration rule’. This rule is established to set aside the management when hostile bids are imminent so that the shareholders have the final say on the merits of the bid. 

    In the Indian context, the rationale for this lies in the structure and organisation of companies. Indian companies typically have concentrated shareholding. They have founding families ‘promoters’ with dominant shareholding positions. This, it has been contended[R27] , blocks against a hostile takeover. As a result, there was no contemplation over promoters not holding large stakes while bringing these regulations. Furthermore, there is an assumption implicit in this rationale that the promoters owe a statutory duty to the company as they are endowed with the scope to act in case of a takeover and not the Board. As the next section establishes, it is ultimately the directors who owe a statutory duty to the company and not the promoters. 

    IV. Section 166: A codification of the stakeholder model

    Section 166 of the Act lays down the duties of directors. This was the first time that India had codified the duties of directors[R28] . Section 166(2) highlights who these duties are owed to. It has been contended that the wording of this provision indicates a concrete shift from the shareholder primacy model to the stakeholder model. The shareholder primacy model is based on the theory that the Board of directors derives its powers from the shareholders and therefore, the role of directors is to promote the interests of the shareholders. The stakeholder model views the company’s activities as affecting the society in genera[R29] l. It emphasizes that the role of a company’s directors is not limited to maximising shareholder value but also to account for the interests of other stakeholders, without prioritising one over the other. Therefore, to summarise, the shareholder-primacy model prioritises the interests of the shareholder at the expense of others in the company. It only recognises the profit-driven stake of the shareholders while the stakeholder model situates the company in the larger society.

    Historically, India has fluctuated between these models. During the colonial and the post-Independence period, we adhered to the shareholder model. With the 1960s socialist era, the company was beginning to be seen as having a public character so, we shifted towards the stakeholder model. But, with the 1990s liberalisation policies, we reverted back to the shareholder primacy model. As a result, there was a recognition that directors owe a fiduciary duty to the existing shareholders. This was reflected in the Companies Bill, 2009 [R210] wherein clause 147(2) recognised that directors owed duties to carry on the business of the company “for the benefit of its members as a whole” i.e., the shareholders. This was later amended by the Parliamentary Standing Committee, which recommended the inclusion of Section 166(2). 

    The UK on the other hand, followed a different trajectory. Through section 172 of the UK Companies Act, 2006 the enlightened shareholder value model was adopted. This is a variation of the shareholder primacy model where directors are required to have regard to non-shareholder interests as a means of enhancing shareholder value over the long term. So, a hierarchy has been created wherein the shareholder interests are at the top while stakeholder interests remain at the bottom. This interpretation of Section 172 has been upheld recently by the UK Supreme Court as well. 

    Overall, it can be seen that India casts a positive duty on directors to account for other stakeholders whereas UK considers this to be a secondary consideration (if a consideration at all). In light of this duty, it becomes imperative to empower directors to act against a hostile bid. 

    V. Why should directors have scope to act against a hostile bid?

    India’s shift towards the stakeholder model signifies that a body which is accountable to the company and its stakeholders shall exercise the broader decision-making power of the company. When seen in this context, it is apparent that the rationale of allowing the promoters to act does not necessarily hold water. This is because promoters do not owe any statutory duty to the company. The 2013 Act prescribes only two duties of promoters: duty not to make secret profit and duty to disclose to the company any interest in a transaction.[i] This is quite limited when compared with the duties of directors under Section 166. Further, in the case of a promoter being a majority shareholder, there are only two restrictionsprescribed by the Act: limit on the power to alter the MOA and limiting the power from committing fraud on the minority.

    More specifically, in the context of a takeover, there is no mandate imposed on the promoter/shareholder to take into account stakeholder interests. Whereas by reading the duties of directors to include the scope to act in a takeover, there will be a positive duty imposed on them. This becomes significant as a takeover can impact other stakeholders such as employees adversely. For instance, during the Mindtree acquisition by L&T, there was the risk of a cultural mismatch as Mindtree followed an informal culture while L&T followed a command-and-control and top-down management. We can clearly see that by empowering only promoters with control to act in a takeover, there can be severe consequences as they are not bound to account for the interests of other stakeholders. 

    Therefore, India can no longer afford to continue following the non-frustration rule of the UK Takeover Code. The rule still works for the UK because it has adhered to the shareholder primacy model. It no longer works for India as our understanding of a company is that of an entity having a public character. This is evident from the mandatory CSR obligations under Section 135 of the Act. 

    VI. Conclusion

    The purpose of this post is to prompt a review of our takeover-friendly SAST Regulations. Our present law is located at one end of the spectrum as it completely prohibits any action by directors during a hostile takeover. However, we are at a unique position where we can attain a balanced position by providing some scope to directors to act while formulating a standard of review of directors’ actions under Section 166. If we continue with our current framework, we are likely to run into problems as in the case of Religare wherein the directors have no choice but to delay the inevitable through vague mechanisms. 

    [i] Erlanger v. New Sombrero Phosphate Co., (1878) LR 3 App Cas. 1218, 1236, Gluckstein v. Barnes (1900) AC 240. Also note that Sections 34 and 35 of the Companies Act impose liability for untrue statements in prospectus and sections 339 and 447 impose liabilities on promoters for fraudulent trading. 

  • Rationalizing ‘Connected Persons’: Analyzing SEBI’s Proposed Insider Trading Amendments

    Rationalizing ‘Connected Persons’: Analyzing SEBI’s Proposed Insider Trading Amendments

    BY PRIYA SHARMA AND ARCHISMAN CHATERJEE, Fourth AND third YEAR STUDENTS AT NATIONAL LAW UNIVERSITY, ODISHA

    I. Introduction 

    Securities and Exchange Board of India (‘SEBI’), in the consultation paper dated 29 July 2024 (‘consultation paper’), proposed amendments to the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’) to rationalize the scope of ‘connected person’. The consultation paper proposes to add additional categories to the current definition of connected persons in the PIT Regulations, and thereby cover more persons who may have access to unpublished price sensitive information (‘UPSI’) by virtue of their relation with an insider.

    While the proposed amendments will help SEBI target additional persons and raise a presumption of possession of UPSI against them, the existing ambiguities in the insider trading legal framework will increase the likelihood of false positives and overregulation in this arena.

    II. Proposed Amendments

    Under the PIT Regulations, an insider is defined as any person who is either a connected person or is in possession of or having access to UPSI. Presently, a ‘connected person’ is defined as a person who is or has, during the six months before the act, been associated with the company, directly or indirectly, in any capacity [Regulation 2(1)(d)]. The relationship with the ‘connected person’ may be contractual, fiduciary or employment-related, and may be temporary or permanent, that allows them access to UPSI or is reasonably expected to allow such access. The PIT Regulations also specify certain categories ‘deemed to be connected persons’, including immediate relatives of the connected person, a holding or associate company or subsidiary company, etc. within its ambit. 

    UPSI is defined as “any information, relating to a company or its securities, directly or indirectly, that is not generally available which upon becoming generally available, is likely to materially affect the price of the securities”. A person who falls under the scope of a ‘connected person’ will be presumed to have access to UPSI, and the person will carry the onus to disprove this presumption. If a person does not fall under the scope of a connected person, the onus to prove access to such information will lie on SEBI.

    The consultation paper notes that certain categories of persons, who have a close and proximate relationship with connected persons, may not be covered under the present definition of ‘connected person’. Therefore, it proposes to replace the term ‘immediate relative’ in section 2(1)(d)(a) with the term ‘relative’. It also proposes the inclusion of additional categories of people who will be deemed to be connected persons, including any person on whose advice, directions or instructions a connected person is accustomed to act, a body corporate whose board of directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a connected person, persons sharing household or residence with a connected person, and persons having material financial relationship with a connected person including for reasons of employment or financial dependency or frequent financial transactions. 

    In order to ensure ease of doing business, the definition of ‘immediate relative’ is proposed to be retained for the purpose of disclosures, and the definition of ‘relative’ is rationalized only for establishing insider trading.

    III. The Good: Targeting a Regulatory Gap

    The changes are proposed with the aim to include persons who may seemingly not occupy any position in the company but are in regular contact with the company and its officers. By virtue of this relationship, such persons may be aware of the company’s operations and get access to UPSI. 

    Under the current regime, the scope of connected persons does not include non-immediate relatives of the person. ‘Immediate relative’ includes the spouse of a person, parent, sibling, and child of such person or of the spouse, any of whom is either financially dependent on this person or consults such a person in making decisions relating to trading in securities. Under the proposed amendments, the term ‘relative’ would include spouse, siblings, siblings of spouse, siblings of parents, any lineal ascendant or descendant of the individual or spouse, or spouse of any of the mentioned persons. Evidently, the new definition will include many more persons.

    Many relevant relations remain uncovered in the present terminology, which requires that either (a) the mentioned person be financially dependent on such a person, or (b) consults such a person in making decisions relating to trading. Such facts are difficult to prove, as they involve the family’s internal affairs, and make it difficult to establish the presumption of insider trading. 

    For illustration, under the current regime, if A is a connected person, B, the father-in-law of A’s sister who lives in another city with her husband’s family, would not be deemed to be an insider unless he fulfills the criteria mentioned in the definition. The proposed amendments would bring B under the ambit of ‘deemed to be connected person’ since he is a lineal ascendant of the sister’s spouse. No other criteria are required to be fulfilled.

    The proposed amendments formulate a comprehensive definition of ‘relative’, much like the Income Tax Act, 1961, and do not limit it to immediate family members. This proposed change promises a stricter, and stronger, regulatory regime.

    IV. The Bad and the Ambiguous: Pre-existing issues

    Section 15G of the SEBI Act specifies that any individual who enters into a trade on the basis of UPSI would be penalized for insider trading. The emphasis here is on the term basis since it showcases the requirement of mens rea for the liability to be attracted. On the other hand, Regulation 4 of the PIT Regulations states that if any individual executes any trade while in possession of UPSI, the liability for insider trading shall be attracted. 

    In this regard, the Supreme Court, in Balram v SEBI, observed that ascertaining the intent of individuals is necessary to affix the liability for insider trading. On similar lines, in Abhijit Rajan v SEBI, the apex court highlighted the need to determine the profit motive of the individuals who are in possession of the UPSI. This showcases a clear conflict between the specific wording of the PIT regulations and the interpretation of the court in terms of the presence of mens rea and increases differences in interpretations. 

    If the proposed changes are implemented, many more individuals would be deemed to be connected persons, and the presumption of access to UPSI will be raised against them, even if the access is factual or not, or any mala fide intent to act upon it is present or not. For instance, B, being the father-in-law of A’s sister, who may be deemed to be a connected person by virtue of being a relative if the proposed amendments are made, is able to overhear certain UPSI at a family function, and despite the same, he sells his shareholding as he intended to do so even before possessing the UPSI. In such a scenario, B could still be liable for insider trading under PIT Regulations even though there was a lack of intent and profit motive. 

    Therefore, the present regulatory framework showcases the lack of uniformity and clarity about the threshold for attracting liability for insider trading, and the issue will be exacerbated if the definition of ‘deemed to be connected persons’ is widened. Additionally, such a low threshold (no mens rea required, according to the PIT Regulations) to hold a person liable might lead to false positives, which in turn may overburden SEBI as well as the accused persons. In fact, it was advised by the N. K. Sodhi Committee, which was formed to review PIT Regulations of 1992, that a defense should be incorporated into the provisions which would allow the insider to prove that the alleged illegal trade has an effect which is opposite to what the UPSI requires for one to draw an unfair advantage.

    To address this, we suggest implementing a higher threshold for those connected persons who are very remotely connected to the primary insider and a lower threshold for those who are directly connected. The current framework treats all immediate persons on the same footing. For instance, an individual who came into accidental possession of UPSI might get prosecuted for the offence of insider trading. 

     The incorporation of a threshold on the basis of a higher burden of proof or requirement of mens rea (possession or usage) could increase the efficiency of the framework. To elucidate, for proving insider trading in the case of relatives by birth, the mere possession of UPSI should be enough to hold them guilty, and the opposite can apply in case of relatives by marriage. Similarly, the burden of proof required to prove their innocence should be lesser for relatives by marriage and the contrary for those related by blood. Such a framework is more effective than the proposed changes, as it does not automatically deem ‘immediate relatives’ as connected persons (as is the case in the present scenario), and instead, creates comprehensive criteria for the regulator to implicate relatives in actions against insider trading. Moreover, SEBI should not overlook profit motive as mens rea and refine the insider trading provisions in the PIT Regulations, bringing it more in line with the Act. Lastly, the addition of more defenses in Regulation 4, such as those recommended by the Sodhi Committee, may help dilute the adverse impacts of the proposed amendments. 

    V. Conclusion

    While the proposed amendments aim to broaden the scope of ‘connected persons’ to encompass those in close proximity to insiders, thereby strengthening regulatory oversight, they also introduce challenges. The potential for increased false positives and ambiguities surrounding the intent requirement highlight ongoing concerns within the insider trading legal framework. To mitigate these issues, SEBI must strike a balance by refining definitions, clarifying thresholds for liability, and incorporating defenses against inadvertent breaches. Such measures are essential to uphold both the integrity of the securities market and the rights of individuals ensnared in the regulatory net.

  • From Bias to Balance: Informed Consent in AI Arbitration

    From Bias to Balance: Informed Consent in AI Arbitration

    BY A.S. VAMSI KRISHNA AND SWAGAT AHUJA, THIRD-YEAR STUDENTS AT RGNUL, PUNJAB

    Introduction

    Recently, there has been a surge of interest in the notion of artificial intelligence (‘AI’) based platforms taking over the role of an arbitrator. This interest stems from their potential to provide a swift and cost-effective alternative to the traditional arbitration process, particularly in light of the fact that over 31 million disputes are currently pending before Indian courts. However, legal and ethical concerns have been raised regarding the use of AI-arbitrators due to their susceptibility to incorporating biases stemming from racial, cultural, religious, and geographic stereotypes into their assessments. For instance, COMPAS, an AI-based risk assessment tool implemented in American judicial systems to predict the likelihood of a defendant becoming a repeat offender, was found to exhibit significant bias. The program inaccurately categorised African American offenders as high risk nearly half of the time, raising serious concerns about its fairness and reliability. These concerns are firmly supported by both the UNCITRAL and  the Indian Arbitration & Conciliation Act, which recognise challenges against a biased arbitrator. Consequently, the question arises as to whether the inherent biases of an AI-arbitrator render it an unusable proposition, even if the parties involved consent to their usage. The answer is not so straightforward, since a blanket ban on the use of AI-arbitration would infringe upon the freedom of the parties to opt for their preferred arbitration process, even if it involves a fully-AI based arbitrator at its helm. 

    The authors argue that a balance must be found between preserving the parties’ freedom to submit their dispute to the arbitrator of their choice against the consideration of potential costs incurred should there be mass-unenforceability of AI-generated awards in courts. To achieve this balance, the authors suggest that AI-arbitration agreements should only be allowed where the parties involved fully understand the biases inherent in the AI-arbitration and provide informed consent accordingly. Further, this article delves into potential measures that could be implemented within a regulatory framework to ensure that parties are capable of providing informed consent to an AI arbitration agreement.

    The Need for Informed Consent

    In the context of AI-arbitration, informed consent must be understood to be fulfilled when the concerned parties have access to sufficient and accurate information regarding the AI’s inherent biases and predisposition prior to entering into the agreement. The need for informed consent is countered by some, who argue that the higher threshold of consent in selecting an AI-arbitrator imposes an unnecessary burden, especially when compared to their human counterparts who, despite sharing susceptibility to inherent biases, are exempt from such requirements. In response, the authors contend that equating AI-arbitrators with their human counterparts would be misguided, since the manner of the manifestation of their biases and the scale of their operations are not comparable. AI in general is in its nascent phase and as such, the methods of investigating inherent biases it may possess are complicated and time-taking. Expecting both parties to be sufficiently knowledgeable on the basis of their own investigations is a big ask and would often lead to challenges at the time of enforcement. This is certainly true in the cases of consumer facing contracts where an AI-arbitrator is employed by banks, large constructors and other large-scale operators, where the opposing party often consists of individuals who lack sufficient resources to investigate the AI-arbitrator thoroughly. Additionally, an AI-arbitrator differs from humans in that the multitude of cases it can resolve is much greater than a single human. This means that any bias challenged by a party in one case would lead to a domino effect, toppling every case it has previously dealt with on the basis of a single challenge. In light of these factors, the element of informed consent is a vital consideration with respect to AI-based arbitration.

    Integrating Informed Consent into AI-Arbitration Platforms

    To ensure that the parties involved are capable of providing informed consent, the regulatory framework must be such that the potential AI-arbitration platforms are examined thoroughly and any inherent predispositions undertaken by the AI is disclosed. However, as previously discussed, the complexity of investigating such AIs means that the regulation in place cannot evolve an independent statutory body which evaluates each AI and certifies it as this would increase the cost and resources of the state. Thus, the authors propose that the potential AI arbitrator should be made open-source, meaning the model whether a language learning model or otherwise on which the AI operates should be publicly accessible to ensure transparency. An open-source AI offers significant benefits, as complete access to its inner workings allows experts worldwide to examine it and identify potential loopholes, emulating a peer-review process of the code. This approach has proven effective, evidenced by the case of ChatGPT, an open-source AI. It was discovered to have inherent biases in favour of a more liberal stance, revealed only by the efforts of a group of experts who carefully examined the code. An open-source AI is preferable to a confidential program since it would reduce arbitration costs for the parties by mitigating the need for private investigations of the code in each case. Additionally, it would be more efficient for the arbitration platform, which would otherwise need to protect the secrecy of its code through rigorous Non-Disclosure Agreements and other tedious privacy measures before permitting parties access for investigation. Therefore, an open-source approach is a win-win situation for the parties involved and the arbitration platform. It ensures transparency regarding any inherent biases or errors within the AI and eliminates the need for parties to conduct an ex-ante investigation for each case.

    Furthermore, an additional element to informed consent is to ensure that the variant of the AI which both parties have tested and agreed is the AI which actually acts as the arbitrator. This factor is relevant in light of the capability of AI to be altered post-agreement due to new updates. For example, if both parties provide consent to appoint an AI variant developed in 2024 as their arbitrator, any subsequent updates to this variant could potentially alter the AI’s assessment of the case. This would create the possibility of challenges during enforcement. Thus, to prevent enforcement errors, AI-arbitration agreements must specify the variant which they choose to act as arbitrator and the AI-arbitration platform must possess the capability to assess disputes as per their previous variants as well. Alternatively, the parties can reach an agreement to consent to the use of the specific AI along with the updates therein to ensure that no claim regarding lack of informed consent leads to challenges during enforcement.

    Conclusion

    AI-based arbitration promises low-cost, expedited dispute resolution, a prospect that is so enticing that it has drawn investments to bring the idea to reality. While parties have the right to opt for AI arbitration as their preferred process, ensuring fairness and equitability is necessary to ensure that the awards so produced are not vulnerable to challenge in courts. It is in the interest of future AI-arbitration platforms to provide parties with the ability to give informed consent to ensure successful enforcement of awards. 

    Further, regulators face a daunting task since they always have to catch-up with the lightning-fast development of AI. Falling behind is not an option, since a defect in the AI-program could impact not just one, but potentially all the awards it has produced. The authors suggest a pre-authorisation process for AI-arbitration platforms, mandating open and peer-reviewed programs to uncover potential biases. This is since AI’s complex nature means that understanding and revealing its potential biases can only be done by a small group of experts and so cannot be expected to be understood by all potential users. Peer review allows for a breakdown of complex information into simple intelligible data that can be understood by the parties before agreeing. Should there be no regulation, the state risks having its people consent to arrangements for which it is not moral to hold them accountable since they are unable to give informed consent. Hence, it is a justified regulatory filter to require AIs to pass certain tests before being released into the market.

  • SECTION 29-A OF ARBITRATION ACT: THE EXIGENCY OF LEGISLATIVE PRESCRIPTION.

    SECTION 29-A OF ARBITRATION ACT: THE EXIGENCY OF LEGISLATIVE PRESCRIPTION.

    BY DIGVIJAY KHATAI AND ZOYA FARAH HUSSAIN, THIRD-YEAR STUDENTS AT

    NLU ODISHA

    Introduction

    Section 29-A (4) of the Arbitration and Conciliation Act, 1996, is currently under scrutiny in India due to its perceived impact on the efficiency and expediency of arbitration proceedings. This provision mandates the completion of arbitral proceedings within twelve months from the date of the arbitrator’s appointment, with an extension of six months by the consent of the parties. Non-adherence to this timeline leads to the cancellation of the arbitrator’s mandate. The issue of allowing extension after the expiry of the mandate arose recently in the Rohan Builders  case which awaits a final decision in the Supreme Court.  In that light, the first section analyzes the uncertainty regarding the contribution of the parties in seeking an extension of the mandate after its expiry. Beyond that, we expound on the dichotomous judicial stance on the said matter and its implications. Finally, we culminate our opinion to understand the need for a statutory prescription on this issue. 

    Comprehending the Conundrum

    In acknowledgment of the need for a fine balance between the two pillars of the Arbitration and Conciliation Act which are party autonomy and time-bound resolution of disputes, the 2015 amendment inserted Section 29-A to the act wherein sub-section (1) limits the time period for the arbitral tribunal to announce the arbitral award within twelve months from the ‘date of completion of pleadings for claims and defences’, which has to be concluded within six months from the date the arbitrator(s) received the notice of appointment as per sub-section 23(4) of the Act. Further the same can be extended, with the consent of the parties for a period not extending six months under sub-section 29-A (3).  

    However, under sub-section 29-A (4), in case the arbitral tribunal fails to announce the award either within the timeline under sub-section (1) or within the extended timeline sub-section (3), the mandate of the arbitrator shall expire, upon completion of such time-period, unless the court extends the same either prior or after the expiry. Sub-section (5) further mandates that such an extension by the court shall be on the ground of a ‘sufficient cause’ that must be proved by the party making the application under sub-section (4).  These provisions enshrine the essence of time-bound efficiency in the statute limiting the period of resolution within twenty-four months from the date of notice of appointment to arbitrators. 

    The legislation explicitly addresses the authority of courts to extend the arbitrator’s mandate, both preceding and following its expiration. However, it remains silent on the specific timing for parties involved in the proceedings to submit an extension request. Hence, the central legal quandary arising from this ambiguity is whether parties must adhere strictly to applying under sub-section 29-A (4) before the arbitrator’s mandate expires, or if they retain the autonomy to do so even after its expiration. 

    Judicial Dichotomy

    The scope of section 29A has been analysed in a catena of judgments. In Rohan Builders case, the Hon’ble Calcutta High Court examined the extension of the arbitrator’s mandate through the interpretation of the word “suspended” in the 176th Law Commission Report concerning section 29A (1). The learned Single Judge referred to this report which proposed using the term “suspension of arbitral proceedings” instead of “terminate” when suggesting the implementation of time limits for concluding arbitration proceedings. However, the statute uses the word “terminate” in recognition of the need for efficacy in arbitration proceedings. This choice implies that once the prescribed timelines expire without extension requests from either party, the tribunal’s authority would cease definitively rather than remain suspended. 

    Relying on the aforesaid judgement, Hon’ble Calcutta High Court in Vrindavan Advisory Services L.L.P. v. Deep Shambhulal Bhanushali rejected an extension application filed after the specified period under section 29A. Notably, the Hon’ble Supreme Court has ordered a stay of the Calcutta High Court’s verdict (given vide order dated November 06, 2023) after an SLP was filed against Vrindavan Advisory. 

    In a sharp turn of opinions, the Delhi High Court in ATC Telecom Infrastructure Pvt Ltd case, ruled that an application under section 29A (4) can be filed after the expiry of the mandate of the arbitrator. It reasoned that since the section has empowered the court to extend the arbitrator’s mandate either ‘prior’ or ‘after’ the expiry of the same, it saw no reason why an application of extension ‘after’ the expiry shall not be entertained. The rationale behind such a stance was justified by the expeditious approach of the arbitrator backed by the consent of the parties for the said extension. These were reasons enough for allowance of the extension application rather than rejecting it merely for filing the same after the expiry of the mandate.  

    The expeditious conduct of the arbitrators was again a crucial ground for the Hon’ble Delhi High Court in Wadia Techno-Engineering Services Ltd. v. Director General of Married Accommodation Project to grant an extension of arbitrator’s mandate despite the parties applying for the same after the expiry of the mandate. 

    Upholding the approach laid down by ATC Telecom (Supra), the Bombay High Court in Nikhil H. Malkhan case, has reasoned that since the courts are empowered under section 29-A (4) to grant an extension after the expiry of the mandate, such power conferred cannot be negated solely by the virtue of parties making application ‘after’ the expiry. 

    Legislative Prescription: A Need

    The approach opted by ATC Telecom, Wadia Techno-Engineering and Nikhil H. Malkhan adopts a logical viewpoint as opposed to a stricter and a more literal approach of the statute solely focusing on the efficiency of proceedings, taken by Rohan Builders. The former not only seeks to accurately construe the legislative intent of section 29-A (4), but it also intends to preserve the element of party autonomy which stands on an equally significant pedestal. While it shall be interesting to see how the Supreme Court balances both the aspects in the SLP filed against the Rohan Builder (Supra), we need to be cognizant of a potential loophole that shall entail at the event of allowance of the parties to apply for extension after expiry of the arbitrator’s mandate. 

    Notably, none of the rulings that advocate acceptance of applications after the expiry of the mandate, prescribe a specific time limit after the said expiry within which such an application must be made. In the absence of such an additional time limit, parties will have a free pass to apply for the extension after any unreasonable delay. For example, recently in Glencore India Pvt Ltd v. Amma Lines Limited case, the Bombay HC laid down that as per the current legal framework and given an expeditious conduct on behalf of the arbitrator, the arbitrator’s mandate may continue to be valid despite an ‘unreasonable delay of 6 months’ attributable to parties applying for extension of the mandate.     

     The direction to apply ‘before’ the expiry of the arbitrator’s mandate in Rohan Builders (Supra) contributes a sense of certainty to the ambiguous maze of specific time limits which the other cases are devoid of, creating an enriched ground for violation of the statute to conclude arbitral proceedings within twenty-four months. The entire scheme of discussions highlights the pernicious implications of enforcing the ATC Telcom approach coupled with an absence of a further statutory time limit, on the efficiency of arbitral proceedings.  

    The creases of the conundrum can be ironed out if a legislative endeavour is sought to be made to not only lay down conditions for extending the mandate under section 29-A(4), which includes expeditious conduct of arbitrator coupled with consent of parties; but also prescribe a specific time limit of say fifteen or thirty days within which an application for extending arbitrator’s mandate is to be mandatorily made. 

    Conclusion

    The slew of judgements paints conflicting pictures on the issue of extension of the arbitration mandate. While the decision in the SLP pending in the Rohan Builders case would be fascinating to observe, the approach to allow the extension of the mandate after the expiry of the timeline taken by another set of judgments does not come as a panacea either. The approach does entail some lacuna like the ‘absence of a specific period’ to adhere to while applying for an extension of the arbitrator’s mandate, after the expiry affects the time-bound efficacy of the legislation. In response to this a need for a statutory prescription of a certain timeline for requesting an extension after the expiry of the mandate has been proposed which could give certainty in such a scenario where the opinions of the courts are divided and act as an uncontested thumb rule to guide further decisions. 

    In conclusion, a balanced outlook to encapsulate the essence of both the pillars of the statute would ensure that both the judiciary and the legislature, in pursuit of endeavouring in the said matter would be guided by the original intent of the legislators. 

  • Bharati Airtel & Anr v. V.V. Iyer – Unraveling the Set-Off Saga in Insolvency

    Bharati Airtel & Anr v. V.V. Iyer – Unraveling the Set-Off Saga in Insolvency

    by Pratishtha Agarwal and Prabhav Tripathi, students of third-year at the Institute of Law, Nirma University

    Introduction

    While the Insolvency and Bankruptcy Code, 2016 (“IBC”) serves as a complete code, many a time, the exclusive nature of the Act presents a legal lacuna in the procedure and calls for determining the application of other general laws in such absence of relevant provisions. On a similar note, in the recent case of Bharati Airtel Limited and Anr. v Vijaykumar V. Iyer and Anr., the Supreme Court decided upon the question of the right to claim set-off in the Corporate Insolvency Resolution Process (“CIRP”). In set-off, it is a debtor’s right to settle the smaller claim owed to him against the larger claim payable to his creditor. As there is no statutory provision on setting off the balance amount once the CIRP has been initiated, the Bench comprising Justice Sanjiv Khanna and Justice S.V.N. Bhatti observed the appeal.

    It was held that insolvency set-off and statutory set-off do not apply to CIRP. Though the right to claim of set-off is generally granted under Order VIII Rule 6  of the Civil Procedure Code, 1908 (“CPC”), it is not permitted in the CIRP when the Resolution Professional proceeds to take control and custody of Corporate Debtor’s assets under Section 25(2)(a) of IBC.

    This blog aims to understand the rationale behind the judgement and the exceptions it carved, discuss the arguments presented from both sides and analyse the dissenting stances of foreign jurisdictions on claim of set-off in insolvency proceedings.  

    Facts of the Case 

    In April 2016, eight spectrum trading agreements were executed between Bharti Airtel Limited, Bharti Hexacom Limited, Aircel Limited, and Dishnet Wireless Limited to acquire the usage rights of the spectrum allocated to the latter. Since the agreement was contingent on the approval of the Department of Telecommunications, Government of India, (“DoT”) it had demanded that the Aircel entities submit bank guarantees for Rs 457.73 crores owing to certain licenses and spectrum dues.

    After the Aircel entities filed a challenge with the Telecom Disputes Settlement and Appellate Tribunal (“TDSAT”)regarding DoT’s directive, they were ordered by TDSAT to provide bank guarantees for which they approached the Airtelentities. On the Aircel entities replacing the bank guarantees furnished by the Airtel entities and Airtel entities receiving them from the DoT, Rs. 411.22 crores were payable by the Airtel entities to the Aircel entities.

    Pertinently, the bone of contention arose on 10th January 2019 when the Airtel entities made a payment of Rs 341.80 crores due to Aircel entities after setting-off a balance amount of Rs 145.20 crores on the ground that Aircel entities owed that amount to them. This set-off was contested before the Adjudicating Authority (“AA”) in Mumbai by Airtel wherein an order in favour of the Airtel entities held that they had a right to set off Rs. 112.87 crores from the payment. The Resolution Professional contested the Adjudicating Authority’s order before NCLAT which held ‘set-off to be antithetical to the objective of the IBC.’ 

    Provisions And Principles: No Right To Claim Set-Off In The CIRP

    Relying upon the opening part of the enactment, the Supreme Court judgement addresses IBC as a complete code to consolidate the laws relating to insolvency resolution and reorganization. The intentional omission of statutory set-off or insolvency set-off provisions during CIRP reflects a legislative decision to preclude the assertion of such rights in insolvency proceedings. Additionally, Regulation 29 of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 (“Liquidation Regulations”) which addresses setoff and mutual credits, is confined to Chapter III Part II, specifically about the liquidation process. This posits that if there were a conflicting legislative intent, the law would have encompassed Chapter II Part II of the IBC to allow the application of set-off claims during CIRP.

    Section 238 IBC provides an overriding power wherein notwithstanding anything inconsistent present in any other law for the time being in force, the laws laid down are in effect. This legal position also disarms Regulation 29 from subsuming the CIRP under its scope of insolvency set-off. Further, Order VIII Rule 6 of CPC creates a legal or statutory set-off wherein the defendant has a right to claim set-off against the plaintiff’s demand for an ascertained sum of money that is legally recoverable and is not beyond the pecuniary limits of the court’s jurisdiction. However, this set-off too, is overridden by Section 238 and rendered inapplicable from being exercised during insolvency proceedings, thus maintaining the rigidity and exclusivity of the Code.

    It was further argued that the concept of insolvency set-off, in its entirety, goes against the principle of pari passu. Section 53 of the IBC lays down the priority order of creditors for the distribution of sale proceeds of liquidation assets under the “waterfall mechanism”. Here, set-off offers an overriding effect and primacy to the creditor entitled to claim set-off against the demanded credits of the Corporate Debtor. In the process of dealing with these cross demands by set-off, the assets are depleted in favour of that single creditor with set-off entitlement that was initially available to be settled amongst the general body of creditors. As a consequence, with a decrease in the dividend payable, the same class of creditors are not treated equally and the liquidation hierarchy is also compromised. Thus, if such a claim is permitted in the CIRP, it is bound to go against the waterfall mechanism by keeping the entitled creditor on a higher footing and the other creditors at a disadvantageous position.

    Contradictory Viewpoint on the Applicability of Set-Off to CIRP

    The SC judgment attempts to clear the air on the applicability of set-off to CIRP however it raises pertinent questions on whether the Apex Court has taken an erroneous stance. The judgment moots the contention that Regulation 29 of the Liquidation Regulationsmandates the mutual set-off however the instant regulation only corresponds to liquidation.

    Pertinently, as noted earlier, the judgment of the SC in the case of Swiss Ribbons v. Union of India held that set-off can be considered during CIRP subject to the challenge before the AA. Interestingly, the judgment takes note of the mandatory nature of insolvency set-offs in the United Kingdom as highlighted by the judgment in the case of National Westminster Bank Ltd. v. Halesowen Presswork & Assemblies Ltd.. Therefore, it is vital to highlight that set-off is a widely accepted and practised principle of insolvency law internationally. Notably, Section 553  of the U.S. Code provides for the right of a creditor to offset a mutual debt that arose before the commencement of the case i.e. pre-petition debt. However, per the ratio of In re Shopper’s Paradise,  it was highlighted that a creditor can never offset a post-petition debt against a pre-petition debt. This in line with the distinction drawed upon in the instant judgment in relation to set-off pre and post the initiation of the CIRP. 

    Further, in the matter of Pramod Kumar Sharma Uniworld Sugars Pvt. Ltd. v. ED&F Man Sugar Ltd., NCLT Chandigarh had held that set-off was permissible during CIRP in view of ‘the treatment reflected in the book of accounts of the Corporate Debtor while determining the liability of the parties with regard to the purchase and sale of sugar.’ A case has been made out in detail below for allowing set-off in the context of CIRP. 

    Justifications for Permitting Set-off in the Context of CIRP

    1. Litigation Minimization: Permitting setoffs can aid in the reduction of litigation throughout the CIRP. The presence of set-off may potentially mitigate disputes concerning the validity and magnitude of claims, as it incentivizes the involved parties to negotiate settlements rather than engage in protracted legal disputes.

    2. Encourages Credit Flow: An effectively operating set-off mechanism has the potential to encourage credit flow. If creditors are certain that the quantities owed by the debtor can be offset against their exposure, they may be more inclined to grant credit to financially distressed companies. This would subsequently increase the availability of credit in the market.

    3. Promoting Creditor Engagement: Permitting set-off enables creditors to be more motivated to actively participate in the CIRP. To encourage greater participation in negotiations, contribution to the resolution plan, and support for the company’s revival, creditors might be more inclined to offset their claims against the liabilities of the debtor.

    Conclusion

    However, the Apex Court has carved out two exceptional conditions in Paragraphs 30 and 32 of the judgement, wherein the set-offs are permitted in CIRP in two circumstances. Firstly, a contractual set-off is allowed if its entitlement is effective before or on the date of CIRP initiation.  As the same cannot be precluded, the terms of the contract remain binding besides the moratorium period. Secondly, equitable set-off, wherein the claim and counter-claim are linked by transactions that can be treated as one, was also made an exception by the Bench. Herein, the set-off needs to be “quantifiable, genuine, and established on fact and in law.” Through this judgement, the Supreme Court reiterated the sanctity and exclusivity of IBC and settled the position of law on the applicability of the right to claim set off in the CIRP. In the context of insolvency law, the ratio decidendi is a right step in the way to establish a proper demarcation of claims in CIRP and other laws.

  • Navigating SEBI’s Upstreaming Clients’ Funds Framework

    Navigating SEBI’s Upstreaming Clients’ Funds Framework

    BY AISHANA AND NIKITA SINGH, THIRD-YEAR STUDENTS AT GNLU, GUJARAT

    Introduction 

    In the past few years, The Securities and Exchange Board of India (SEBI) has taken several steps to safeguard investors’ securities and funds, but a significant amount of investor funds may still be vulnerable to the risk of potential misuse. To mitigate the same, in a recent regulatory move, it has released a circular that lays out a crucial framework for stock brokers (SBs) and clearing members (CMs) to upstream their clients’ funds to clearing corporations (CCs). The circular is a strategic step to protect customers’ money and guarantee its prudent use, with important ramifications for investors and the securities market alike.

    The SEBI circular mandates the upstreaming of all client funds received by SBs and CMs to CCs in the form of cash, lien on fixed deposit receipts (FDRs), or pledge of units of mutual fund overnight schemes (MFOS). Specific conditions are outlined for creating FDRs, including the requirement that FDRs should be pre-terminable on demand and lien-marked to one of the clearing corporations (CCs) at all times. Guidelines for pledging MFOS units are introduced to ensure minimal risk transformation of client funds and exposure to risk-free government securities. The circular also emphasizes measures to improve operational efficiency and reduce transaction costs, along with compliance and monitoring mechanisms for stock exchanges and CCs. 

    In this article, the authors will explain the conditions outlined for creating FDRs including the guidelines introduced for pledging MFOS units, aiming to mitigate risk transformation and limit exposure to risk-free government securities, which will be examined in detail. Moreover, the article also encompass the circular’s overarching goals of improving operational efficiency, reducing transaction costs, and establishing robust compliance and monitoring mechanisms for both stock exchanges and CCs. 

    The Purpose and Rationale of the Framework

    The principle behind the framework for upstreaming of clients’ funds by SBs and CMs to CCs is that no clients’ funds should be retained by SBs and CMs on end of the day basis. This means that all the clear credit balances of the clients, i.e., the funds that are not required for meeting the margin or settlement obligations of the clients, should be transferred to the CCs every day. The CCs are the entities that facilitate the clearing and settlement of trades in the securities market. They act as the central counterparties and guarantee the settlement of trades, thereby reducing the counterparty risk and enhancing the market integrity. The sole purpose of the framework is to protect client funds from abuse or misappropriation on the part of SBs and CMs. Additionally, it seeks to guarantee that the clients’ money is placed in low-risk or risk-free products, like government bonds, and that it is accessible to fulfil their obligations as needed. By including procedures for collateral utilisation and margin adjustment, the framework also aims to lower transaction costs and increase operational efficiency for market players. In addition, it also aims to improve upstreaming process compliance and oversight by requiring reporting and audits from stock exchanges, CMs, CCs, and SBs.

    The Forms and Conditions of Upstreaming

    The framework allows three forms of upstreaming of clients’ funds to CCs: cash, lien on Fixed Deposit Receipts, or pledge of units of MFOS. It also specifies certain conditions for creating FDRs out of clients’ funds such as FDRs must be pre-terminable on demand, allowing redemption without any penalty or loss of interest. Secondly, it should be consistently lien-marked to one of the CCs, serving as collateral and necessitating CCs’ consent for withdrawal or transfer by SBs or CMs. Thirdly, It also must be issued by scheduled commercial banks with a minimum A1+ credit rating, excluding co-operative and regional rural banks and should be in the name of the SB or CM, explicitly mentioning “client funds.” Furthermore, these FDRs should exist in dematerialized form within a depository, with daily reports sent to CCs by the depository, ensuring transparent oversight and compliance with the SEBI circular. These stringent conditions underline SEBI’s commitment to meticulous risk management and client fund protection within the securities market. 

    Moreover, the guidelines are also laid down for the pledging of Mutual Fund Overnight Scheme (MFOS) units derived from clients’ funds. To ensure transparency and effective oversight, these MFOS units must exclusively exist in dematerialized form within a depository, with daily reports dispatched to CCs by the depository. Pledging procedures involve the units being pledged in favour of CCs through the depository system, with the pledge remaining valid until released by the CCs. Valuation of the MFOS units is pegged at the previous day’s net asset value , and the application of a haircut by CCs is capped at 10% of the unit’s value, exemplifying a cautious approach to risk management. Crucially, upon the release of the pledge by CCs, the redemption of MFOS units must occur on the same day, with the proceeds seamlessly credited to the client nodal bank account of the SB or  CMs. These guidelines underscore SEBI’s commitment to meticulous risk mitigation, transparency, and ensuring the seamless utilization of clients’ funds within the regulatory framework of the securities market.

    The Applicability and Monitoring Mechanisms of the Circular

    The framework applies to all SBs and CMs in all segments of the securities market but also holds some noteworthy exceptions include Bank-CMs, encompassing clearing members that are banks providing clearing and settlement services, and the proprietary funds of SBs and CMs, specifically reserved for their individual trading pursuits. Augmenting the effectiveness of this framework are various monitoring mechanisms outlined within the circular. To ensure meticulous implementation, stock exchanges and CCs are tasked with creating systems capturing daily details of clients’ funds received and upstreamed by SBs and CMs, with reconciliation against reports from depositories and banks. Periodic inspections and audits of SBs and CMs, conducted by stock exchanges and CCs, serve as a means to verify compliance, with a commitment to take appropriate action against any defaulters. Additionally, these regulatory bodies are obligated to submit quarterly reports to SEBI, offering insights into the circular’s implementation status, any deviations encountered, and the corresponding corrective measures taken. Simultaneously, SBs and CMs are entrusted with maintaining meticulous records of clients’ funds, readily providing them to stock exchanges, CCs, and SEBI upon request. With an effective date set for July 01, 2023, this framework reflects SEBI’s proactive stance in fostering transparency, accountability, and adherence to regulatory norms within India’s dynamic securities market.

    The Impact and Implications of the Circular

    The framework also necessitates the compliance of SBs and Clearing Members (CMs) in upstreaming all clients’ funds to CCs on a daily basis, following prescribed forms and conditions. This requirement curtails the flexibility and discretion of SBs and CMs in managing clients’ funds, potentially impacting their liquidity and profitability. They are also burdened with the operational costs and risks associated with the upstreaming process, including charges for creating FDRs or pledging MFOS units, and the risk of default or delay in the redemption of these instruments. Furthermore, they must adhere to the reporting and audit requirements imposed by the circular, facing consequences for non-compliance.

    On the other hand, CCs stand to benefit from an increased inflow of funds from SBs and CMs in the form of cash, FDRs, or MFOS units, thereby expanding their collateral pool and enhancing their risk management capabilities. However, they are tasked with building mechanisms for collateral utilization and margin adjustment to facilitate the upstreaming process and reduce transaction costs for market participants. Additionally, they are responsible for monitoring the compliance of SBs and CMs with the circular and reporting the same to the Securities and Exchange Board of India (SEBI).

    From the clients’ perspective, the framework offers several advantages. Their funds are safeguarded from misuse or misappropriation by SBs and CMs and are invested in risk-free or low-risk instruments. The pre-terminable nature of FDRs and MFOS units ensures that clients have access to their funds whenever required, with the possibility of same-day redemption. Moreover, the oversight of stock exchanges, CCs, and SEBI over the upstreaming process ensures greater transparency and accountability in the management of their funds. Thus, while the framework imposes certain constraints on SBs and CMs, it ultimately serves to protect the interests of clients and enhance the robustness of the financial system.

    Concluding thoughts 

    It can be concluded that the implementation of the circular’s guidelines will require concerted efforts from all stakeholders in the securities market. SBs and CMs must ensure strict adherence to the conditions for creating FDRs and pledging MFOS units. Stock exchanges and CCs, on the other hand, must bolster their compliance and monitoring mechanisms to ensure the effective implementation of these guidelines. Moreover, continuous dialogue and feedback mechanisms should be established to address any challenges that may arise during the implementation phase. This will not only ensure the smooth execution of the circular’s mandates but also contribute to the overarching goal of safeguarding investors’ securities and funds. The circular represents a significant step towards a more secure and efficient securities market. By ensuring the prudent use of customers’ money and reducing potential misuse, it paves the way for a more robust and investor-friendly securities market in India.